Back From The Shadows

The microfinance industry charges very high interest rates, no question. But when the government puts a ceiling on rates, the cure is worse than the disease.

It has happened and continues to happen in Bolivia, Ecuador, Colombia and El Salvador. Every so often, some journalist who knows nothing about microfinance discovers that the interest rates charged by microfinance institutions are 30% or 40% annually, and he immediately thinks he has a headline.

"Usury rates," writes one. "Why microenterprise cannot develop," protests another. "Scandal in microfinance." or "The poor pay the most for loans," and so on. The public becomes impassioned over these institutions that charge the poor more than traditional banks charge the rich and soon the government, or some member of parliament looking for a populist cause, decides to put a ceiling on interest rates. The result? The financial industry goes into crisis because it cannot grant loans at rates that are lower than its costs, or it finds itself obligated to use financing from donors to directly subsidize microcredit.

The truth is that this is an expensive business," says Efraín Camacho, general administrator of the Bolivian Superintendency of Banks and Financial Entities. "The monitoring and collection costs are higher than those for other types of credit, more information about customers is required and the large number of small customers requires more infrastructure and more staff to serve them."

To this is added the high staff turnover in the microfinance industry, and scant methodology that exists to measure risk in the sector. "Recently specialized credit scoring tools are beginning to emerge," continues Camacho, "all adding up to the industry having high administrative costs."

There are also high financial costs. An additional risk premium must be paid when obtaining resources from traditional banks, and private financial development funds charge 100 basis points over the traditional funds. With regard to traditional investors, they see more risk in these entities and risk rating firms penalize them. And it is even worse if a microfinance institution wants to be regulated; the costs of auditing, submitting reports and the payment to the superintendency for the procedure to change status must be added.

Even so, in countries where the industry is more developed, interest rates have dropped. "In Bolivia, when the business began, interest rates were around 80% (annually)," says Jacques Trigo, former treasury minister, superintendent of banks and financial entities and president of this country's Central Bank. Now, they are around 25%." Camacho adds, "The market has done its work with regard to the price of resources."

According to Omar Balladares of the private financial fund, PRODEM of Bolivia, the drop in rates "has been due to competition more than anything." His institution charges rates between 23% and 25%, "but we have a cooperative across the street that charges 16%."

In addition, the industry has diversified in terms of its portfolio with specific products such as flash credit, which is approved in six hours, without guarantee, but with an interest rate of 45%.

Over the last 20 years, the government and Bolivian legislators have almost always allowed free rates, which has encouraged the industry to develop, services to expand and interest rates to drop. However, government intervention in controlling rates is "something that returns from the shadows," says Trigo.

|sidebar| Who Has Interest Rate Ceilings?

Bolivia placed a ceiling on interest rates in early 2004 through a decree that prohibited charging over 2.5% per month. "Fortunately, this was only used for one month," recalls Camacho. "It was assumed that we had convinced the government of the need to have free rates, but unfortunately, this was not the case," explains Trigo. "Therefore, we have to approach the politicians, maintain permanent dialogue with them to explain that if a rate is imposed that chokes the market, the alternative is to return to the loan sharks' and usurers' informal rates of 60% or more."

With regulated rates below the break-even point of the costs, business ceases to exist and another phantom reappears: state development banks that subsidize the interest rate.

Evidence shows that when the industry is opened to competition and the market allocates resources—and Bolivia itself is the best example—interest rates tend to fall. "When customers are good payers, the risk premium drops," explains Trigo, "and therefore interests rates drop."

Options

Allowing microfinance institutions to accept deposits is one of the ways officials' actions would help interest rates fall because it would give these institutions an additional source of income and the opportunity to guarantee credit.

Colombia has established the so-called state "guarantee funds," which transfer to the state the cost of the financial risk that microfinance institutions normally assume. "The system is turning out better than we hoped," says specialist Beatriz Marulanda. "The guarantee fund helps increase access, but has not had a big impact on the rate."

Marulanda explains that the Colombian regulatory system is taking the industry seriously. The superintendency of financial institutions has included microcredit as a different category in order to rate the portfolio.

The country has a "usury ceiling" for interest rates, which is 1.5 times the current bank interest rate. The current bank interest rate has steadily declined in recent years from 42.6% in 1998 to 25% in 2003. The ceiling of 1.5 times [the rate] would not have been viable for the microfinance industry, were it not for the authorization in 2001 to charge an additional commission to microcredit transactions, explains Clara de Ackerman, chairperson of Womens World Banking Colombia. "The solution made it possible for MFI's to be viable by charging additional commissions, not computed in the usury limit, in addition to the interest rate," she explained during a presentation on subject at the Cartagena forum.

In Peru, the interest rate for microfinance institutions fluctuates around 45% annually, but "they make us compete under unfavorable conditions with commercial banks," explains Luis Guerra, of Edpyme Edyficar Peru.

Doing what is done in terms of liberalization, efficiency, diversification of lines of business, it is certain that the interest rates for the microfinance industry will continue to be higher than traditional banks. They may drop 20% as is the case in Bolivia, but "loans for the rich" will continue to be cheaper. Therefore, the public relations problems of microfinance institutions will continue.

"The best argument to counteract this is transparency," explains Edgar Carvajal, IDB specialist in Ecuador. "Clearly explain the cost of administering the credit and how much the commissions are."

"When someone asks us how it is possible for the microfinance industry to charge 50% interest to poor people when traditional banks charge the rich 10%," says Trigo, "all we can say is what the alternative would be, that there would be no credit. And the interest rate for credit impossible to obtain is an immeasurable credit rate."